Key yield at '02 high on inflation worry

Solid demand at 10-year auction gives market some relief

By

RachelKoning

CHICAGO (CBS.MW) -- U.S. Treasury prices fell and yields held at summer 2002 highs Thursday as signs of accelerating inflation kept alive expectations for a Federal Reserve interest-rate hike as early as next month.

Data on producer prices pressured the bond market after showing a sharp rise in the main index, but its core rate, an adjusted measure that excludes volatile food and energy prices, was tamer. Separate reports on retail sales and jobless benefits claims were both softer than forecasts, but when taken in the context of the past few months showed continued U.S. economic strength.

The market pared its decline briefly after a 10-year note auction, the final leg of the government's quarterly borrowing package, met with solid demand, even from the central banks that some thought might pull away from U.S. debt now that currency-market intervention has slowed.

The benchmark 10-year Treasury note closed down 9/32 at 93 11/32. Its yield
TNX, +1.27%
used in setting mortgage and corporate borrowing rates, rose to 4.86 percent vs. 4.80 percent at the previous U.S. close. A close at this level hadn't been seen since July 5, 2002, according to Federal Reserve data. See the latest on mortgages.

The Fed is seen having to buffer the U.S. economic recovery against rising inflation by raising interest rates. Bond bears are wary that the Federal Reserve may have left U.S. interest rates accommodative for too long and may have to respond with aggressive policy changes.

A rising rate environment cuts the value of some bond investments, as new debt will have to offer higher yields. If the Fed is behind the curve on inflation, bonds are more likely to lose value on their fixed interest payments.

The 10-year note's yield could move as high as 5.50 percent over the next 12 months, said Bill Tedford, fixed-income strategist with Stephens Capital Management in Little Rock, Ark.

He thinks Alan Greenspan & Co. may have to use relatively rare half-point moves to get the Fed's 46-year-low 1 percent lending target back to neutral over coming months.

"Traders still give a 90 percent chance of a 25-basis-point tightening following the June 29-30 FOMC meeting," said Daniel Jester, an economist with West Chester, Pa.-based Economy.com, citing market activity through Wednesday. "Successive 25-basis-point hikes are expected in August and in September, which would bring the Fed's target rate to 1.75 percent." A basis point equals 0.01 percentage point.

Inflation, retail and jobs

Wholesale food and energy prices jumped in April, driving the PPI up a higher-than-expected 0.7 percent, the Labor Department said.

Energy price pressures may not abate any time soon. Crude crossed over $41 a barrel in Thursday trading. See Futures Movers.

Core producer prices rose 0.2 percent, in line with expectations. Economists surveyed by CBS MarketWatch had predicted a 0.3 percent rise in the overall PPI and a 0.2 percent rise in core prices.

But the pace of wholesale inflation is accelerating. Over the past year, the PPI has risen 3.7 percent, while the core PPI has risen 1.5 percent.

"The core finished goods gauge has risen at an average pace of 0.2 percent per month in the first four months of the year after advancing by 1 percent over all of 2003, so there has been a modest acceleration," said Steve Stanley, economist with RBS Greenwich Capital, in Greenwich, Conn.

"In contrast, modest is not the word that comes to mind when describing the core intermediate goods figure, which surged 1.1 percent in April, the largest rise since January 1995. In fact, the gauge has risen by 0.6 percent or more in each of the first four months this year."

Inflation watch

Concerns are now zeroing in on Friday's consumer price index, which in recent months has trended higher.

The increased concern was especially evident in the Treasury Inflation Securities, or TIPs, market, with the yield spread between 10-year TIPs and 10-year Treasurys increasing 16 basis points since Tuesday and 28 basis points during the past two weeks, Crescenzi said.

"The current spread indicates that market participants expect the consumer price index to average 2.76 percent over the next 10 years, a substantial leap from a year ago when the spread was closer to 1.60 percent," Crescenzi said.

Meanwhile, markets had been expecting retail sales to cool from March's feverish pace, and the April data met that prediction.

U.S. retail sales dropped 0.5 percent last month, reversing only part of March's 2 percent rise, according to a Commerce Department report. It was the first decline in seasonally adjusted sales since September.

Economists had been expecting a decline of about 0.3 percent, according to a survey conducted by CBS MarketWatch. With the upward revision of 0.2 percentage points to March sales, April sales were in line with expectations. See Economic Report.

Finally, the latest weekly statistics from the job market offered little evidence to refute a trend of slowing layoffs.

The number of people filing for unemployment insurance for the first time rose in the latest week, while the average number of initial claims over the past four weeks fell to its lowest level since November 2000, the Labor Department said.

First-time claims in the week ended May 8 rose by 13,000 to 331,000, while the average number of initial claims over the past four weeks fell by 7,750 to 335,750, the department said.

Economists say the four-week average is more accurate than the volatile weekly number, which is subject to large revisions due to weather, holidays and other effects.

Bond prices were broadly lower. The 3-year note sold earlier this week was trading down 2/32 at 99 23/32 in Thursday trading. Its yield rose to 3.22 percent vs. 3.20 percent at the previous close.

Solid demand

The Treasury Department on Thursday sold $15 billion in 10-year Treasury notes at a yield of 4.848 percent. The agency received $2.78 for every $1 in securities sold, up from a 2-1 ratio in February, the last time the 10-year notes were sold.

Indirect bidders, which include foreign central banks, took 43.5 percent of the notes auctioned, little changed from the 45.3 percent auction share in February, a supportive sign for the bond market.

Buying from Japan and China -- the No. 1 and No. 2 foreign holders of Treasury debt -- so far this year had been responsible for pulling up bond prices and keeping U.S. interest rates at their lowest levels in decades through late March.

Both nations routinely turned currency-intervention proceeds, earned by selling their home currencies for dollars in order to keep exports competitive, into U.S. debt holdings, but intervention has waned over recent months.

In other news Thursday, the Bond Market Association said new issuance in the U.S. bond markets hit $1.46 trillion in the first quarter, about 15 percent lower than the same period a year ago and about the same amount as in the final quarter of 2003.

Treasury issuance has contracted in part as the government collects heftier tax revenue owed to an improving economy.

The association expects to see continued demand for capital in the asset-backed and corporate sectors as the economy improves and issuers take advantage of low interest rates that are expected to rise.

As the nation works to plug its deficit hole and local governments do the same, there will be "a continuing need for debt financing in the municipal bond and Treasury markets," Micah Green, president of the bond association, said in a statement.

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